Aggregate Implications of Corporate Debt Choices

This article studies the transmission of financial shocks in a model where corporate credit is intermediated via both banks and bond markets. In choosing between bank and bond financing, firms trade-off the greater flexibility of banks in case of financial distress against the lower marginal costs of large bond issuances. I find that, in response to a contraction in bank credit supply, aggregate bond issuance in the corporate sector increases, but not enough to avoid a decline in aggregate borrowing and investment. Keeping leverage constant while retiring bank debt would expose firms to a higher risk of financial distress; they offset this by reducing total borrowing. A calibration of the model to the Great Recession indicates that this precautionary mechanism can account for one-third of the total decline in investment by firms with access to bond markets.